Chapter 2
Cost Analysis and Classification
Systems
What is cost?
'the resources consumed or used up to
achieve a certain objective'
Cost classification systems
Cost analysis involves classifying costs
according to their common characteristics. There
are a number of different classification systems,
each differing according to the purpose to which
the cost data is to be used.
Cost classification by element.
Cost classification for control (direct and indirect).
Cost classification by cost centre.
Cost classification by behaviour.
Classifying costs by element
Cost classification for control
One of the responsibilities of management is to
ensure costs are minimised without a loss of
quality to the product or service provided. To
control costs, one must be able to trace costs to
either a product line or a department. This can
help management identify where cost over-runs
have occurred, identify the problems and decide
on appropriate solutions. The process of tracing
costs to departments or product lines involves
classifying costs according to whether they are
direct costs or indirect costs.
Direct cost
‘expenditure that can be attributed to a
specific cost unit’
CIMA Official Terminology
Indirect cost
‘expenditure on labour, materials or services
that cannot be economically identified with a
specific saleable cost unit’.
CIMA Official Terminology
Direct v indirect cost
Example - Hotel
Example 2.1: Calculation of direct
material cost
Example 2.1: Solution
Example 2.2: Calculation of direct
labour cost
Example 2.2: Solution
Example 2.3: Calculation of direct
expenses
Example 2.3: Solution
Prime cost
The prime cost can be established as follows:
Cost classification by cost centre
This is an extension of cost classification for
control purposes. A cost centre is a location or
person or item of equipment for which costs may
be ascertained, and for which an individual is
responsible.
Cost classification by cost centre
Cost classification by behaviour
Cost classification by behaviour is primarily used for
management planning decisions. It is a crucial
classification in that it allows an insight into how
costs react to different circumstances. In trying to
predict and plan for the future, it is essential to
understand costs and what drives and creates costs.
In particular, this classification looks at the
relationship between costs and sales volume /
production output. When planning to increase output
(sales volume), it is important to understand and
appreciate how costs will react to this.
Cost classification by behaviour
'the way in which cost per unit of output is
affected by fluctuations in the level of activity'.
Variable cost
Fixed cost
Example 2.4: Cost behaviour
Example 2.4: Solution
Variable cost
Variable costs are costs that
increase as sales or production
volume increases.
Examples would include direct
materials (cost of food or
beverages for a restaurant or
toys in a toyshop)
Variable costs in total change in
response to changes in activity
levels.
Variable cost per unit will remain
constant in relation to changes in
sales activity.
The graph illustrates the variable cost of producing a meal in a restaurant is €2
and, as sales volume increases, the variable costs increase. The variable cost
graph shows that the variable cost of producing 2,000 meals is €4,000 and the
variable cost of producing 4,000 meals is €8,000.
Fixed cost
Fixed costs are costs that are
a function of time rather than
sales activity and thus are not
sensitive to changes in sales
volume.
Examples of fixed costs would
include rent, rates, insurance
and management salaries.
Fixed costs in total do not
change in response to
changes in sales activity
levels.
Fixed cost per unit will change
in relation to changes in sales
activity.
The graph shows that fixed costs are
€2,000 per week.
Relevant range
In some situations increases in activity (volume)
can affect the cost structure.
For example a significant increase in volume
could result in an increase in fixed costs, if the
activity increases to a level where additional
fixed resources are required then there will be
can be a significant increase in fixed cost.
Step cost
Some costs are called step
costs due to the fact that
they are fixed for a given
level of activity but they
eventually increase by a
significant amount at some
critical point.
Examples include renting
an additional warehouse
unit or hiring an additional
supervisor when activity
reaches a critical point.
The graph shows that fixed costs are €2,000 up to an activity level of 2,000 meals.
At this point the fixed costs increase significantly. Again at 4,000 meals another
critical point is reached and fixed costs increase again.
Semi-variable cost
This graph shows the fixed and
variable elements of a typical
landline telephone charge as
described above.
This graph shows the fixed and
variable elements of a mobile
phone charge where the user
pays a fixed charge for a required
level of usage (number of
minutes) after which the user
pays for each phone call.
Separating semi-variable cost
Accounts analysis method
High-low method
Scatter-graph method
Linear regression
Accounts analysis method
Under this method each cost is examined and, using
judgement and experience, classified into fixed, variable
and semi-variable categories. The semi-variable
category is further apportioned individually into its fixed
and variable components, normally on a percentage
basis. This method is based mainly on experience and
personal judgement and thus can be quite subjective.
Management can however, reduce this level of
subjectivity as follows.
Asking a person associated with the cost item who knows its
behavioural pattern and can give a best estimate of the variable
and fixed components to the cost.
Analysing how the cost item has responded to sales volume
levels in past periods before categorising the cost.
Accounts analysis method
The main advantages of the accounts analysis
method is that it is quick and inexpensive,
however the subjectivity involved can lead to
inaccuracies. Where the cost item is immaterial
and is largely fixed or variable, then the
accounts analysis method is acceptable.
However if this is not so, other more scientific
methods should be used with the accounts
analysis method providing the first stage of a
more analytical approach to cost behaviour
analysis.
High-low method
The high-low method is a statistical method that establishes a
cost to sales volume relationship based on past observations of
how the cost reacted to changes in sales volume.
This relationship is expressed in terms of the cost function y = a
+ b (x).
The high-low method focuses on the highest and lowest levels of
activity (sales volume) within the relevant range over a period of
time.
The total cost at these two extreme levels of activity is recorded
and the difference is attributed to the behaviour of the variable
cost element, which changes as activity levels change. The
process seeks to calculate this variable element. The fixed
element can then be calculated to complete the cost function.
High-low method – the steps
1. Identify the high and low activity levels and record the
cost at each level.
2. Calculate the difference in activity levels and the
difference in costs.
3. Divide the cost difference by the difference in activity
levels. This gives us the variable cost per room sold
(b).
4. Take either the high or the low activity level and input
the data including (b) as calculated in step 3 and solve
the equation by finding the fixed cost element.
Example 2.5: High-low method
Example 2.5: Solution
Scatter-graph method
The scatter-graph approach is a statistical method that
uses historical data to determine cost behaviour. The
scatter-graph approach plots on a graph, all the historic
observations of the cost items in relation to the activity
levels of the business, within the relevant range. A line of
best fit is then drawn visually through the data on the
graph. As with the high-low method, the form of the line
is assumed linear. The angle or gradient of the line
represents the variable cost per unit and the fixed cost is
the point where the fitted line intersects the vertical axis.
Example 2.6: Scatter-graph
method
Example 2.6: Solution
The data is plotted on the graph and a line of best visual fit is drawn
and extends down to the Y (total cost) axis. The point of intersection
with the Y axis represents the estimated fixed costs in this cost
equation, which amounts to €2,900. The variable costs can be
calculated by inputting the fixed cost and the total cost figures into a
cost function based on any activity point on the line of best fit.
Linear regression – least squares
method
This method is a statistical approach to determine the
line of best fit for a given set of data. It is an extension of
the scatter-graph approach and is based on the principle
that the sum of the squares of the vertical distances from
the regression line to the plots of the data points is less
than the sum of the squares of the vertical distances
from any other line that may be determined. In other
words a truly objective line of best fit is calculated which
minimises the squared deviations between the
regression line and the observed data.
Linear regression – least squares
method
Example 2.7: Linear regression
Example 2.7: Linear regression
Example 2.7: Linear regression
Separating semi-variable cost
Each method will give a different cost function.
Of the three methods, the linear regression
model is considered to have the least number
of limitations. The cost function can be used in
the intelligent prediction of future costs based
on forecast sales activity